In the coming weeks, Congress will again debate increasing the debt limit. his is a meaningless exercise in that the debt limit has failed to constrain the growth of debt in the long term. Further, uncertainty regarding congressional approval increases the risk premium on short-term debt and increases the cost of servicing the debt.
Debate on the statutory debt limit obscures the challenge posed by the real debt limit. In high debtor countries such as ours the probability of default on the debt increases risk premiums and could ultimately close off access to bond markets. No one is suggesting the United States is Greece or that it will default on the debt in the near term. However, with total public debt in excess of GDP, America is now in a post-Keynesian era. This “debt overhang” limits the fiscal policy options of the federal government.
Prior to the Great Recession, total public debt was 60 percent of GDP, and the government had fiscal space to pursue Keynesian fiscal policies. With the American Recovery and Reinvestment Act, President Barack Obama increased federal expenditures by $831 billion, on top of increased expenditures to fund automatic stabilizers. A massive increase in the money supply enabled the government to pursue this expansionary fiscal policy without increasing interest rates. Today, the federal government has little fiscal (or monetary) space.
The government cannot pursue such expansionary fiscal policies without increasing the risk premium on public debt. CBO concludes the federal government no longer has the flexibility to respond to recessions or other fiscal emergencies.
In our forthcoming book, Restoring America’s Fiscal Constitution, we reach the same conclusion. Using a dynamic simulation model and CBO forecast data, we estimate the impact of a future recession on budgets and the economy. In a mild recession the government could offset some revenue shortfall, funding the automatic stabilizers. But, in a major recession, debt would increase toward the debt limit, causing even greater instability in capital markets than that experienced during the Great Recession.
However, this post-Keynesian fiscal world may be a blessing in disguise. Since Milton Friedman’s early work, monetarist economists have argued that fiscal policy should be limited to the automatic stabilizers. But because of the accumulation of past debt, the government may now be forced to abandon discretionary fiscal policy out of necessity, rather than by choice.
Fiscal policy in this post-Keynesian world requires fundamental reform of fiscal policy at all levels of government. Corporations and banks should prepare for capital markets without federal rescue of insolvent institutions. Banks that pursue imprudent lending policies should anticipate bankruptcy. Capital markets will then signal an efficient allocation of loanable funds.
State and local governments should also prepare for a world without federal bailouts. If states such as Illinois continue to pursue imprudent fiscal policies, they should anticipate receivership, similar to that in Puerto Rico. Cities such as Chicago that incur unsustainable debt should anticipate bankruptcy, rather than bailouts from state and federal government. State and local governments that pursue prudent fiscal policies, by contrast, will be rewarded for accumulating dynamic credence capital.
Keynesians will counter that governments can continue to incur deficits and accumulate debt as they have for half a century. But citizens will not allow the government to muddle along with fiscal policies that push us closer to the real debt limit. The Founding Fathers incorporated Article V in the Constitution to give states the power to correct the “commission of errors” by the federal government. Failure to address the nation’s fiscal problems would constitute such an error.
Thus if Congress and the president cannot impose fiscal discipline, citizens should do so with new fiscal rules. In so doing, the United States would follow the precedent set in European countries, enacting balanced budget requirements and expenditure limits as constitutional and statutory measures. “No bailout” rules would be an important part of these new fiscal rules.
One way or another, the government must come to grips with our new post-Keynesian world.
[Originally Published at RealClearPolicy]